It's a tad ironic, given that it's probably the only truly recession-proof business in the world. Above all else (except oxygen), humans need water to survive. Yet, water utility company stocks are second only to banks and long-distance carriers in this year's race for last place; they're down an average of 5.5% year-to-date versus the market's gain of 19%.

What gives? And more importantly, when will the bears ease up?

The answer to the question is - unfortunately - probably not very soon. Before jumping to any conclusions though, a little bit of perspective may be in order.

It's All Relative

First and foremost, know that water utility companies have been, and generally remain, profitable. The net margin of the average listed water utility stock over the past twelve months has been 6.9%. However, when the losses incurred by American Water Works (NYSE:AWK) and Southwest Water Co. (SWWC) are taken out of the equation, the average net shoots up to 11.7%. Not bad.

The average P/E for the last twelve months (again, excluding the two losers) is 21.4 when factoring out one-time write offs. However, investors should know that very few water utility stocks posted one-time charges. So, the average P/E of 21.4 is actually a reasonably fair representation of the business.

Don't misunderstand - any price multiple in the 20's is a tad on the pricy side, but for a utility company of all things it's just plain ugly. But....

...it's actually cheaper than the norm. Yes, that's right, water utility stocks boast a stunningly high 5-year average (which includes an economic boom and a bust) P/E of 26.4, and that's excluding any one-time charges. Between 2004 and now, the peak average P/E was 32.9, and the trough average was 18.0. Aqua America (NYSE:WTR) gets the pinnacle award with its high P/E of 41.5 during that time, while SJW Corp. (NYSE:SJW) posted the lowest of the low during the five year span with its multiple of 14.6.

And just to make affirm you're not imagining things here, yes, we're talking about water utility stocks with a long-term average P/E of 26.4.

But Isn't Cheaper Better?

On the surface, sure, an average P/E under the long-term (and we do mean long-term) average P/E would usually mean a value opportunity. In this case though, an exception may be in place.

Think back to 2004. If you need a refresher, that was the point when water - clean, potable water to be specific - started to become a buzz word. The fear of dwindling fresh water supplies started to become a reality, and water stocks literally doubled in price between the end of 2004 and the end of 2005.

Guess what though... the market missed the target, by a mile. At the time (and still today), very few water utility stocks actually have anything to do with water purification or desalination.... the two industries that will actually benefit from scarce water. Investors gravitated towards the wrong stocks for two key reasons - a lack of publicly-traded companies doing any real work on water infrastructure, and a lack of any real understanding of what underlying problems need to be solved.

Oh, that's not to say a water utility company can't or won't make an impact on the water purification problem. When it's all said and done though, Middlesex Water Co. (NASDAQ:MSEX) is mostly just interested in selling water to its customers in New Jersey and Delaware. It's the Basin Waters (BWTR) - which are few and far between - that are actually attacking the water shortage problem directly.

That's the long way of saying the average P/E of 26.4 is not only an anomaly, but also excessive. It's unlikely a water utility company can even support a P/E above 20 (and so far they haven't).

Outlook

So, what's a fair value for water utility stocks? It's tough to pinpoint one, but a P/E of 15 feels a lot more palatable than one above 20. If that right guess is anywhere close to being on target, then the average stock in the group is overpriced by about 40%.

That's not to say each stock must fall 40% before finding a floor, as earnings are on the rise and will likely support prices before the full 40% slide is realized. The premise is still the same though.... the valuations are still oddly high.

With all that being said, a caveat applies (as always) - there are exceptions simply because the averages don't take individual situations into account. The point was only to provide benchmarks, which we did.

Just be honest when it comes time to make an exception though, as most of these names aren't too far from the baseline.

About the author:

James Brumley

James Brumley is a freelance writer and registered investment advisor. He began his career as a broker with a major Wall Street firm, where fundamentals and long-term holding periods were core strategies. After that, he switched gears completely, becoming an analyst at a short-term trading newsletter that focused on technical analysis. He now manages client money using the best of both philosophies. His company, Bluegrass Portfolio Management, offers investors an opportunity to reap superior returns with minimized risk. Go to http://bluegrassportfolio.com/ to learn more.

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